Economic Survey: Fiscal Rules: Lessons from the States

ECONOMIC SURVEY 2017 CHAPTER WISE ANALYSIS

Fiscal Rules: Lessons from the States

States’ Journey towards Fiscal Consoldiation

India like several other countries, embarked in the mid-2000s on an ambitious project of fiscal consolidation. The most well-known and best-studied part of this project was the Fiscal Responsibility and Budget Management (FRBM) Act, adopted by the centre in 2003. This Act was mirrored by Fiscal Responsibility Legislation (FRL) adopted in the states, laws that were no less important than the FRBM, since states account for roughly half the general government deficit.

Success of Fiscal Responsibility legislation

At first blush, the FRL seem enormously successful. The financial position of the states improved considerably.

Most states achieved and maintained the target fiscal deficit level (3 percent of GSDP) and eliminated the revenue deficit soon after the introduction of their Fiscal Responsibility Legislation (FRL).

Another indication that the FRL had a significant impact is that states kept a tight rein on wage and salary expenditure. Instead, they expanded more discretionary spending, which would be easier to scale back if needed to achieve the deficit targets. Borrowing by state utilities also fell after the FRL.

Other Consolidating Measures

However, the FRL was not the sole impetus behind this impressive fiscal performance. Acceleration of GDP growth, increased transfers from the Centre, decline in interest payments and increased central CSS expenditure contributed significantly to such consolidation. Desisting from splurging rather than belt-tightening was probably the real contribution of the States.

As an incentive for states to adopt fiscal rules and to enable them to achieve these fiscal targets, the central government provided a conditional debt restructuring window, the Debt Consolidation and Restructuring Facility (DCRF). The change in deficits and other fiscal indicators in FRL time should consequently be seen as a result of both the FRL targets as well as the debt restructuring facility.

Centre has also prevented fiscal deterioration by exercising Article 293 (3) of the Constitution. Under this clause, States must take consent of the Centre for additional borrowing.

Mechanisms under FRL

The FRL aimed to impose fiscal discipline through a number of mechanisms:

Fiscal targets were established, which were the same for all states: the overall deficit was not allowed to exceed 3 percent of GSDP at any point.

The 12th Finance Commission allowed states to borrow directly from the market, in the hope that investors would also exercise some discipline, by pushing up interest rates on states whose fiscal position had not improved.

Finally, broad public discipline was enhanced by introducing new reporting requirements. States were required to publish annual Medium-Term Fiscal Policy reports.

Way Forward

Fiscal challenges are mounting because of the Pay Commission recommendations, slowing growth, and rising payments from the UDAY bonds. Moreover, macro-economic conditions will not be as favorable to states as they were in the mid-2000s. States should be making use of their surplus cash balances first before taking on additional borrowing. Going forward greater market-based discipline on state government finances will be a major imperative. And, the Centre must take the lead not only in incentivizing fiscal prudence by states but also by acting as a model through its own fiscal management.

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